How to Mitigate Risk in a Portfolio of Contracts

Transcription

1 How to Mitigate Risk in a Portfolio of Contracts BY dr. mark d antonio Organizational management must use the resources they are entrusted with in the most judicious manner possible. An organization must consider if the return of any contract is worth the effort, the opportunity cost, and the risk. This article discusses how an organization can manage its project portfolio as a whole unit, comparing contract return relative to contract risk. It also explores how managers can mitigate overall organizational portfolio risk. Introduction The circumstances of business require that investors be compensated for risk. As such, organizations need to generate adequate return for contract risk. This article explores how an organization might evaluate cash flows and risks as a portfolio of contracts. The questions addressed in this analysis are: 1) Will the use of the Discounted Cash Flow Model help to assess the best contracts that organizations might invest in? and 2) Can risk analysis of contracts using expected return and the coefficient of variation help to produce a balanced portfolio of contracts that mitigates risk? Organizations must consider a methodology on how to determine contract selection. Capital rationing 1 solves some of these questions because organizations have only so much capital. Organizations should focus on the development of balanced portfolios of contracts for two reasons. The first is that organizations must earn a rate of return that is sufficient for them to continue to operate. Contract returns must exceed the organizational cost of capital. The second reason is that the organization should not be overly dependent on any one industry, vendor, or contract because this subjects the organization to additional and unnecessary risk. The risk of any single contract can be mitigated and spread over many contracts in different areas. Let us take a look at some of the managerial challenges of contract management by looking at the triple constraint. The Triple Constraint In a program management or contracting environment, project goals are identified within the triple constraint. 2 The triple constraint contains three factors that are imperative to the success of the contract or project: Cost (budget); Schedule (due date); and Scope (required deliverables). The success of the contract is directly related to all three. FIGURE 1 on page 34 shows a visual representation of the triple constraint. 3 The triple constraint also involves tradeoff because the aforementioned constraints compete for resources. 4 For example, with enough time, almost any deliverable can be supplied. Likewise, unlimited funding can also have a About the Author DR. MARK D ANTONIO is a professor of business at Northern Virginia Community College (NVCC). He was involved with government contracting for 20 years before his academic career. He was the program head of the contract management program at NVCC until Journal of Contract Management / Summer

2 Figure 1. the triple constraint positive effect on the accomplishment of goals and deliverables. In the real world, there are limits to time, funding, and even to the level of performance. The estimation of time and costs within the schedule becomes more important as the size, number, and importance of the contract portfolio grow. As a result the proper estimation of costs, contract return on investment and contract risk are key concerns in contracting. Further, the triple constraint does not consider contract risk. Payback Period Analysis The payback period refers to the number of years (or periods) that are required to recover the initial investment output for a project. 5 An organization typically wants to recover its investment as quickly as possible. As a result, elementary calculations comparing cost expenditures with projected cash flows are made in order to determine about how long it would take to recover the investment. A simple example would be: A contract requires a $10 million initial investment and is expected to generate cash flows of $2 million annually over the next eight years. What would the payback period be? In this case, $10 million divided by $2 million would yield an answer of five years. Thus, planners might have a rough estimate of when the costs for this contract would be recovered. However, the payback period analysis does not account for the time value of money. That is, cash flows that are projected to be received in the future are not worth as much in the present, so the payback period is not precise. Future Value, Present Value, and the Discounted Cash Flow Model Large contracts often have years of up-front costs and negative cash flows followed by years of positive cash flows. Treating all of these cash flows the same is inaccurate. The Discounted Cash Flow Model (DCFM) is a numeric model that attempts to value future cash flows by calculation of their present values (PV). The basic PV formula is a variation of the more intuitive future value (FV) formula, which gives the value of a present sum in the future. FV is a concept that most people can understand. Most people would be able to grasp the question, How much money would I have if I deposited $100 in the bank today at 4 percent annual interest in one year? The FV formula is FV = PV X (1 + i) n. The answer is FV = 100 X (1.04) 1 = $104. The PV formula for a cash flow is an algebraic version of this formula and is represented as PV = FV/(1 + i) n. FIGURE 2 on page 35 shows the details. 6 PV is a concept that is not clearly intuitive to most people. PV might be thought of as the mirror image of FV. For example, the FV statement earlier could be worded differently in terms of PV: How much money would I have to put in the bank today at a 4 percent rate to have the total of $104 in a year? This problem is worked out in the same fashion using the PV calculation (an algebraic version of the FV calculation): PV = FV/(1 + i) n or PV = 104/(1.04) 1. In this case, the PV = $100. The Cost of Capital (Hurdle Rate) Different organizations have different costs for capital and, as such, the hurdle rate for each firm might be different. The hurdle rate, also known as the cost of capital, is the rate that must be exceeded for the organization to make a profit. For-profit firms would calculate a hurdle rate based on their weighted average cost of capital, which is a combination of the weighted average between the firm s percentage costs of debt financing added to the percentage cost of equity (i.e., stock) financing. 7 This is important because it explains why and how the cost of capital/hurdle rate is different between firms and why it is so important. Since the hurdle rate between organizations can vary greatly, a contract or project may be a good investment for one firm and a poor investment for another firm. The DCFM is a better model to use than the payback period because the DCFM considers the time value of money. The DCFM more accurately reflects the current value of the future cash flows. The DCFM can even be enhanced by using an inflation factor for cash flows far in the future. A portfolio 34 Summer 2013 / Journal of Contract Management

3 PV = Present Value (the value of the future amount in today s dollars) FV = Future Value (the amount collected in a future period) i = Interest or discount rate (loan rate or the cost of capital or hurdle rate) n = the period of the analysis (2nd year, 3rd year, nth year, etc.) Figure 2. present value and future value formulas of contracts using the DCFM should consider four factors when evaluating project inclusion: Return, Opportunity cost, The hurdle rate, and Diversifiable and nondiversifiable risk. Example Let us examine a capital budgeting contract for the ABC Corporation to build a plant to manufacture riding lawn mowers. Let us say the cost to get started is $6 million. The firm has data to support that sales will be strong at $899 per unit for three years. The organization has a cost of capital of 9 percent. For this example, we assume all cash flows are received at the end of each year. Since the DCFM analysis used in this example is only a three-year period, an inflation factor was not considered. The spreadsheet shown in FIGURE 3 shows annual sales estimates, revenues, and the DCFM. FIGURE 3 also shows the projected revenue of $11,431,684 and the DCFM of the three annual discounted cash flows of $9,602, Management must weigh the project based on its overall return and must decide if that return is acceptable. The organization must be able to exceed the cost of the capital. How might we calculate the rate of return for this or any contract? The total PV is $9,602,887.82, and if we subtract the investment amount out of the DCFM, we can calculate a return. We can then compare the return to our cost of capital. Subtracting the $6 million investment from the $9,602, PV gives us a profit of $3,602, The rate of return is calculated with a financial calculator using the negative initial cash flow (-6,000,000) and the positive cash flow of $9,602, and the period of three years. The return for the period is about percent annually. Since the cost of capital for the ABC Corporation was 9 percent annually, as indicated earlier, it seems that the project is a good one because we easily exceed this 9 percent hurdle rate. However, one thing not considered is the level of risk. Since risk and return are two sides of the same coin, neither the payback period nor the DCFM tell the whole story for contract investment. 8 Risk Risk is often characterized as some sort of peril or danger. Expected return is a tool that plots a probability distribution of the likelihood of an event happening. To make this easy, let us say that we projected the returns of a contract under three different economic conditions. These conditions are poor, good, and excellent. There are many more possibilities or variables a planner might consider, including ABC Corporation Sales, Revenue, and NPV Projections for Three Years Year # Date Annual Sales Estimate Annual Revenue (Discounted) Present Value of Annual Revenue ,922 $3,525,878 $3,234, ,216 $3,790,184 $3,190, ,578 $4,115,622 $3,178, Totals 12,716 $11,431,684 $9,602, Figure 3. the abc corporation dcfm analysis (at sales price of $899 per unit) Journal of Contract Management / Summer

4 Actual Minus Expected Return Squared Multiplied by Economic State Contract Return for Weighted Amounts Squared Poor Good Excellent Expected Return ---> Variance ---> 2940 Standard ---> Figure 4. example of expected value for contract a intermediate states of the economy, government budget cuts, consumer confidence, contract life cycles, and the like. The organization has completed projects before and has the benefit of experience knowing the likelihood of the economic conditions. If the organization determined the likely return under each of these conditions, they could build an expected return table as shown in FIGURE 4. FIGURE 4 shows that there is a 30-percent probability of poor economic conditions, a 40-percent chance of good conditions, and a 30-percent chance of excellent conditions. Any organization should factor this into any methodology they use since the DCFM returns shown for each economic probability are different. In this case, FIGURE 4 shows that under poor conditions, the organization can expect a 60-percent loss. It shows that the probability for a poor economic show for Project A is 30 percent (0.3), so multiplying this by the 60-percent loss would yield a weighted figure of -18 percent. If this is done for the other economic conditions and added together, it produces an expected return of 10 percent. However, this is only part of what FIGURE 4 shows. By taking the probabilities and subtracting the expected return, FIGURE 4 shows the actual deviation (i.e., the probability minus the expected return). If the actual deviation is squared, the squared deviation is calculated. Finally, multiplying the probability by the squared deviation for each economic condition and summing them gives the project variance (2,940). The square root of the variance is the standard deviation of the project. Standard deviation is an excellent measure of risk because it shows the variation of the project in percentage. FIGURE 4 shows an expected return of 10 percent and a standard deviation of percent. Let us look at Contract B in FIGURE 5. FIGURE 5 looks like FIGURE 4 but it has a few glaring differences. While the return is the same as FIGURE 4 at 10 percent, it is clear that the variation in returns is much less. That is, the large gains and losses from FIGURE 5 (under return for probability) are gone and less disbursed rates of return are displayed in FIGURE 6 on page 37. Thus, the variance and the standard deviation are much lower. But what does this mean? While the return of 10 percent earned in Project B is the same as Project A, the amount of risk (standard deviation) in project B (3.87 percent) is much less than that of Project A (at percent). This means that the risk-adjusted return, or amount of risk taken per unit of return, is far less than Project A. This makes Contract A the more efficient and superior contract. Minus Expected Return Economic State Contract Return for Weighted Amounts Squared Poor Good Excellent Expected Return ---> Variance ---> 15 Standard ---> 3.87 Figure 5. example of expected value for contract B Squared Multiplied by 36 Summer 2013 / Journal of Contract Management

5 Figure 6. calculation of the coefficient of variation Let us take a look at a number of other combinations of risk and return for projects that are on a different return level than Contract A and B. Let us say that contracts C, D, E, and F all have different levels of risk and reward. What does all of this mean? What can be done with the calculation of the expected return and the standard deviation? Let us take a look at the relationship between the two. The Coefficient of Variation The coefficient of variation is a tool that shows the measurement of risk per unit of return. It is very useful in determining the most efficient contract opportunities when the expected returns and risks are not the same. 9 It is calculated by dividing the standard deviation by the expected return. FIGURE 6 shows the formula. If we take the data shown in FIGURES 4 and 5 and some hypothetical numbers for other contracts, we can calculate the coefficient of variation according to the formula shown in FIGURE 6. This data can then be used to determine how any one contract stacks up regarding its risk/return ratio to other contracts. It may be helpful to a firm to engage in contract work that has a risk/return ratio within a certain range. FIGURE 7 on page 38 shows the coefficient of variation for six different contracts. FIGURE 7 shows that the variance of the coefficient of variation in the six contracts is widely dispersed. Using the coefficient of variation, we can see that some contracts have much greater risk relative to their returns. In FIGURE 7, we can see that Contract A has a high level of risk relative to its return. Contract A shows a meager return of 10 percent and a large standard deviation of 54.22, giving a coefficient of variation of 5.42, or 5.42 units for risk for each unit of return. If you compare this to Contract B, you can see that the same level of return, 10 percent, can be achieved at a much lower level of risk (standard deviation of 3.87). This yields a coefficient of variation of 0.39, or 0.39 units of risk for each unit of return. This is a far more favorable risk/return ratio. The remaining contracts are also shown and as the returns increase, the level of risk generally increases. This is consistent with common knowledge of risk and return. Note that the most efficient ratio of risk to return is Contract B. Contract A has the highest risk relative to return. The other contracts are in between. Imagine that ABC Inc. and other organizations have dozens of contract choices and they can organize them to consider the risks and rewards in order to pick the most efficient combinations. The coefficient of variation is a good measure of how efficient a contract is regarding risk and return. That is, an organization might aspire to choose only projects with a certain return, but it may also require the same contracts to be within a certain range of risk. Opportunity cost refers to the concept that because we cannot have everything, we are forced to make choices. That is because if we chose A, we cannot have B. Basically, opportunity cost is the value or forgone cost of the next best option. 10 Organizations are saddled with limitations varying from capital to time. However, how would an organization specifically evaluate the contracts that it is considering? Contract Portfolio Analysis Which projects should an organization do? The answer is in part based on the simple premise of risk verses return. Basically, a contract should be assessed to determine how many units of risk are being taken for each unit of return received. If we were to plot the risk and return of each contract on a chart, we would have the grouping of points similar to FIGURE 8 on page 39. FIGURE 8 shows a letter (referring to a contract being considered) representing the risk and return of the contract. If all of the possible contracts that are available were plotted on a graph, a manager could view the risk/return ratio of each Journal of Contract Management / Summer

6 Coefficient of Variation Contract/ Project Standard Expected Return Contract A Contract B Contract C Contract D Contract E Contract F figure 7. the coefficient of variation Coefficient of Variation with the risk on the X axis and the expected return on the Y axis. Ultimately, the very best projects would form a frontier of the contracts with the very best risk/reward relationship, which is represented on the solid line in FIGURE The solid line passing from Contract B to Contract F in FIGURE 8 represents the very best returns for each level of risk. Contract combinations northwest of the solid line do not exist and contract combinations southeast of the solid line would have less efficient and inferior risk/return relationships. Obviously, an organization would prefer to have projects that were on the frontier, or close to it, indicating that the risk/ return ratio is among the most efficient available. The important issue in considering any contract is whether it fits into the overall portfolio of contracts for an organization. What we really need to do is to express the overall portfolio risk/return ratio for the organization. Another way of looking at the portfolio is to consider an analysis of the risk adjusted return rather than just the return, and return that is diversifiable through other investments. 12 Note that while Contract F delivers greater return, it would require the acceptance of a much higher level of risk. Having said this, and depending on a number of other factors, Contract F may still be an acceptable and excellent addition to the project portfolio of some organization. The organization may make a decision on this based on the size or length of a contract or how many projects it has that are similar or different to the contract being considered. Contract choice is important from the standpoint of organizational goals and missions and it is important for maximizing profit or utility. Further, the organization must also consider the project life cycle and the length of the project. It must consider when the cash flows are received from the project. Further projects have overlapping deadlines and maturities and differing sizes and capital needs over different time periods. The idea here is to spread the risk over multiple different types of contracts or projects. This is very similar to the methodology used by a stock portfolio manager when managing assets within a portfolio. Investments can act as a natural hedge for other investments, thus mitigating risk passively in portfolios. 13 For example, a firm might be taking additional risk when it issues a cost reimbursement contract for a construction project in a time when building materials are increasing in price. A mixed portfolio that also contains contracts with fixed-price clauses would mitigate the overall risk. The organization should consider many factors when evaluating contracts because contract types are not perfectly correlated and a collection of them can help the organization to avoid diversifiable risk. Will the use of the DCFM help to assess the best contracts that organizations will want to invest in? The answer to this question is yes, but not alone. The DCFM is certainly a good way to evaluate returns by cash flows that occur over many months or many years, but it does not consider risk. Can risk analysis of contracts using the expected return method help to produce a balanced portfolio of contracts that mitigate risk? The answer to this question is yes if reliable probability, cash flow, and discount rate data are available. An organization can evaluate multiple projects and determine the most efficient contracts that are currently available based on risk and return. This contract analysis can be improved with the introduction of other factors such as consideration of the contract term, inflation, project size, vendor dependency, and industrial diversification. Government regulations, budgetary rules, and tax changes may have an effect on the capital budgeting decision process for contract selection. The frontier of efficient contract investment (FIGURE 8) was presented as if the relationship between risk and return was strictly linear. This is most certainly not the case. Summary and Conclusion It is important that organizations receive adequate return for contract risk. This analysis explored one way an organization might measure risk and return. It also examined cash flow analysis, expected value, and the coefficient of variation to consider how an organization might treat a collection of multiple contracts as a whole portfolio and use individual projects to mitigate the risks of others and overall organizational risk. The International Federation of Accountants in Business, in their paper on project appraisal, stated that the DCFM helps to frame decisions to focus on value. 14 However, for contract portfolio balance, the organization should consider more than 38 Summer 2013 / Journal of Contract Management

7 figure 8. chart of the risk and return of contracts a, b, c, d, e, and f just the rate of return. In addition, the organization should consider if that rate of return exceeds the cost of capital. The organization should consider a number of factors when applying capital to various contracts. The organization must pursue a policy of return that exceeds its cost of capital. However, it must also pursue a policy of prudence with regard to risk. Since most organizations have limits to the quantity of capital that they have, the organization must examine and evaluate opportunity costs and determine the most efficient contracts to invest in. The key points made by this analysis include: Organizations must consider more than just the return on a contract; The organization must also consider the risks of contracts; The organization should consider the relationship between contract return and contract risk; Only the most efficient contracts should be pursued; The organization should also avoid dependence in any vendor, industry, or contract type because this subjects the organization to additional and unnecessary risk; and A portfolio of contracts is similar to an investment portfolio and the risk of any single contract can be mitigated and spread over many contracts in different areas. JCM Endnotes 1. Capital rationing is a contracting and finance concept stating that resources (such as capital) are limited and so only the very best choices regarding the use of capital should be made. 2. See Jack R. Meredith and Samuel J. Mantel Jr., Project Management: A Managerial Approach (Hoboken, New Jersey: John Wiley and Sons, 2012). 3. Derived from Triple Constraint, available at 4. Meredith and Mantel, op. cit. 5. Arthur J. Keown, John D. Martin, and J. William Petty; Foundations of Finance (Upper Saddle, New York: Pearson Prentice Hall, 2011). 6. Derived from Harold R. Kerzner, Project Management A Systems Approach to Planning, Scheduling, and Controlling (Hoboken, New Jersey: John Wiley and Sons, 2009). 7. See Michael H. Moffett, Arthur I. Stonehill, and David K. Eiteman; Fundamentals of Multinational Finance (Upper Saddle, New Jersey: Pearson Prentice Hall, 2012). 8. See Andrew Springett, The Pension Strategy (Toronto: Insomniac Press, 2004). 9. See Eugene F. Brigham and Joel F. Houston, Fundamentals of Financial Management (Mason, Ohio: South-Western Cengage Learning, 2009). 10. See Stephen Slavin, Economics (Chicago: Irwin, 1996). 11. Henry Markowitz developed an efficient frontier in his discussion of asset allocation, risk, and return. (Henry Journal of Contract Management / Summer

8 Markowitz, Portfolio Selection, The Journal of Finance 7(1) (1952): ) 12. See Eugene F. Brigham and Joel F. Houston, Fundamentals of Financial Management (Mason, Ohio: South-Western Cengage Learning, 2009). 13. See Moffet, et al., note International Federation of Accountants in Business, Selected Tax Credits (2012), available at files/publications/files/project-appraisal-using-dis.pdf. 40 Summer 2013 / Journal of Contract Management